Fiscal policy tools and the fiscal multiplier

What can a government spend money on?

Government spending takes three forms.

• Transfer payments are welfare payments through the social security system: state pensions, housing and child benefits, tax credits, income support and unemployment benefits. They give low-income households a minimum income and change the distribution of income. They are not part of gross domestic product (GDP), because they do not reward a factor of production, and they are not counted as government spending on goods and services.
• Current government spending buys goods and services on a regular, recurring basis: health, education and defense. It shapes a country’s skills and labor productivity.
• Capital expenditure is infrastructure investment: roads, hospitals, schools, prisons. It adds to the capital stock and the economy’s productive potential.

Fiscal tools

• Government spending Memorize
  • Transfer payments pensions, unemployment and child benefits, income support; not in GDP
  • Current government spending recurring: health, education, defense
  • Capital expenditure roads, hospitals, schools, prisons; adds to capacity
• Taxes Memorize
  • Direct taxes on income, wealth and profits
    • Income, wealth, corporate profits, capital gains
    • Payroll or employment taxes, property, inheritance
  • Indirect taxes on spending
    • Value-added or sales tax
    • Excise duties: fuel, alcohol, tobacco; gambling taxes

Spending is justified on economic and social grounds: to provide services such as defense that benefit everyone, to build infrastructure that helps growth, to guarantee a minimum income, to manage aggregate demand for low inflation and high employment, and to subsidize new, high-risk industries such as alternative energy.

How does a government raise money?

Direct taxes are levied on income, wealth and corporate profits. They include capital gains taxes, payroll (employment or national insurance) taxes, corporate taxes, local income and property taxes, and inheritance tax. Indirect taxes are levied on spending: value-added taxes (VAT) or sales taxes and excise duties on fuel, alcohol and tobacco. Health and education are often exempted on social grounds.

Taxes can serve social aims as well as raise revenue. Tobacco and gambling taxes deter use, and fuel duties make travel more expensive for environmental reasons.

Exam tip A payroll tax falls on labor income, so it is direct. If it is added to the price at the register, it is indirect.

Economists judge a tax system by four attributes, which can conflict.

Four desirable attributes of tax policythey can conflict

• Simplicity easy to comply with and enforce; liability certain
• Efficiency distorts choices as little as possible
• Fairness horizontal equity: like pays like; vertical equity: richer pay more
• Revenue sufficiency raises enough to fund spending

Most people accept that income tax should be progressive (richer pay a larger share). Some argue for a flat rate for simplicity. A rise in income tax meant to cut a deficit may reduce work effort, so revenue sufficiency can clash with efficiency.

Go deeper Supply-side arguments about incentives

Supply-side economists argue that high income taxes cut the incentive to work, save and invest, and that cuts and simplification raise work effort and investment. The evidence is mixed: work effort may rise, but tax cuts have had little effect on saving. Tax reform debates cover flat rates, consumption taxes, indexing to inflation and the taxation of dividends and estates.

Which tools are fast and which are slow?

Memorize

Advantages	Disadvantages
Indirect taxes adjust almost immediately and raise revenue cheaply	Direct taxes and benefits need months of notice, because payroll and benefit systems must be changed
Social aims (less tobacco, alcohol or fuel use) can be pursued instantly through excise duties	Capital projects take years to plan and build, so they are poor short-term stabilizers, though they add to capacity
Announcements can change behavior before a measure starts	The slower a measure, the more likely the economy has moved on before it bites

Announcements can work as fast as the measure itself: a tax rise announced for next year can cut spending today, although the evidence for this is mixed.

Tools also differ in potency. Direct government spending moves aggregate output more than an equal income tax cut or transfer rise, because part of a tax cut is saved. The exception is a transfer or tax cut aimed at the poorest households, who spend almost all they receive.

Go deeper Spending versus a tax cut of the same size

Take MPC 0.90, net tax rate 40% and multiplier 2.174. A spending rise of 50 adds 50 straight to demand, so output rises 50 × 2.174 = 108.7. A lump-sum tax cut of 50 gives households 50 but they spend only 0.90 × 50 = 45 in the first round, so output rises 45 × 2.174 = 97.8. Same size, weaker effect.

How does the fiscal multiplier work?

Memorize

New government spending becomes someone’s income. They pay tax, spend a share of what is left, and that spending becomes another person’s income, round after round. The total effect is a multiple of the first round. Three quantities set the multiple.

• The marginal propensity to consume (MPC) is the share of each extra unit of disposable income that is spent.
• The marginal propensity to save (MPS) is the share saved, so MPS = 1 − MPC.
• The net tax rate $t$ is taxes less transfers as a share of income. It leaves households with disposable income $Y_D$.

$$Y_D = (1 - t)\,Y$$

Households spend MPC of what is left, so each round passes on only $MPC\,(1 - t)$ of the last. The rounds add up to a geometric series, which sums to the fiscal multiplier .

$$k = \frac{1}{1 - MPC\,(1 - t)}$$

With no taxes it reduces to $1/(1 - MPC) = 1/MPS$, which overstates the effect, because taxes are a leak from every round, as is saving.

$$\Delta Y = k \times \Delta G$$

Go deeper When the multiplier is smaller in practice

The formula assumes unused labor and capital and constant prices. Near full employment, extra demand raises prices instead of output, so the true multiplier is smaller. In an open economy some spending leaks abroad as imports, shrinking it further. Automatic stabilizers also damp the response to any shock, because they lower the effective multiplier.

What is the balanced budget multiplier?

Memorize

If a government raises spending and taxes by the same amount, output still rises, because households cut spending by only the MPC share of each unit of tax, while the government spends the whole unit. The balanced budget multiplier is 1: output rises by exactly the amount of the balanced change.

$$k_{BB} = 1$$

Go deeper Why the result is exactly 1

The spending multiplier is $1/(1-c)$ and the lump-sum tax multiplier is $-c/(1-c)$. Add them and the sum is $(1-c)/(1-c) = 1$, whatever the value of $c$. The curriculum states the rule as a fact to remember: a balanced budget change in spending and taxes raises output by the same amount.